Democracy Rules: Why Business Thrives in Democratic Societies

Recent data suggests that in countries which have made the transition from “Not Free” or “Partly Free” to “Free” (according to Freedom House) the average rate of GDP growth increased from just over 6% to over 14%. Countries categorized as “Free” also seem to draw more overseas investment: while the total level of US foreign direct investment (FDI) in “Free” countries is well over $250 billion a year, FDI in “Not Free” countries remains under $20 billion.

For some, though, China’s recent success stands as a counterpoint to the idea that democracy is better for business and economic development. Multinational corporations as well as local companies have fared extremely well over the course of China’s last 30 years of economic development, which was accomplished under an autocratic regime. China’s economic triumphs indeed deserve recognition, but weak rule of law seems likely to inhibit continued growth.

By most accounts, more than 90,000 protests occur in China every year, a manifestation of popular discontent with corruption and other instances of officials disregarding the rule of law. The villager revolt in Wukan at the end of 2011, for example, highlighted the role that corruption plays in issues such as income inequality and access to capital. In Wenzhou last summer, a high-speed train crash that killed at least 40 people can be traced to improper implementation of safety protocols. Instead of investigating the incident and punishing those responsible for the lapse, officials attempted to cover up the wreckage, literally. And while local officials deny it, the practice of police abducting “suspects” without due course is reportedly widespread. Add to this numerous labor strikes, and many companies are naturally concerned about their ability to maintain the productivity of their workforce.

Issues surrounding intellectual property (IP) rights are also a major threat to many companies. This goes beyond pirated movies and fake Puma sneakers (or “Pumba” sneakers as I have seen in local shops). When foreign companies do business in China, they often run the risk of having their patented technology copied, reproduced with minor alterations, and then re-patented. This naturally leads to a loss in competitiveness resulting in reduced revenues. Foreign companies have often invested in Chinese projects only to be shoved out by local competitors who have managed to replicate proprietary information. Such behavior has led to some major losses and many businesses rethinking whether or not it is worth it to do business in China.

Foreign investment is not the only victim of lax regulation regarding intellectual property. A recent article exploring the topic suggests that the value of a Chinese start-up’s IP is generally discounted by between 33 percent and 50 percent. Weak institutions for protecting property deter investment in new ideas and reduce the drive to innovate. Why spend time, energy, and resources to engage in productive innovation when there is no guarantee of being able to profit from it?

Such disregard for laws and regulations has a direct impact on investors, both foreign and domestic, who fear their money may be squandered. The general consensus is that China must now transition away from its export-based model and foster a more robust domestic market. However, would-be entrepreneurs — the agents of growth and development — are effectively denied the ability to convert their assets into capital, and so are unable to turn ideas into reality. Domestic companies and start-ups are also hindered by regulations put in place to prop up the state champions that have driven growth over the past three decades.

Unlike China, democracies are built on institutions that help to foster an environment conducive to enterprise, where citizens and businesses are able to voice their opinions and contribute to the development and enforcement of laws and regulations. Democratic societies are also more transparent, allowing for greater accountability and more effective and fair enforcement of the law. When officials are accountable to the public, they have a larger stake in tackling issues such as corruption that inhibit economic growth. Additionally, wider access to information helps to arm businesses with the knowledge they need to make important decisions and conduct effective strategic planning.

Recently, questions have arisen about whether or not China can maintain its high rate of growth. In a recent discussion at the Carnegie Endowment for International Peace, Justin Lin of the World Bank stated that he is confident that China has the potential to continue growing at rates of over 8 percent for at least 20 more years. However, in order to do so, the reforms that Deng Xiaoping initiated in 1978 must be completed. This process includes the removal of market distortions that support state-owned champions, the development of a reformed financial system that allows local entrepreneurs to access capital, and much stronger rule of law. Without such reforms, growth may falter in the face of problems related to the rule of law and corruption.

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The CIPE Development Blog provides coverage of the Center for International Private Enterprise and its partner network at work -- highlighting successes, drawing out lessons from failure, and exploring the broader issues of political and economic development. For more information visit CIPE.org.